This paper proposes a new trade-off for emerging-market sovereign borrowing. Borrowing in local currency insulates sovereigns from default but increases the severity of bond fire sales in bad times, as local-currency bonds are endogenously held by intermediaries vulnerable to fire sales. We present three facts. First, investors with open-end funding structures who are subject to performance-based withdrawals hold most external local-currency debt. Investors with long-term and stable funding prefer to hold hard-currency bonds. Second, when open-ended intermediaries face funding withdrawals, local-currency bond prices fall differentially and issuers reallocate by issuing in hard currency. Third, issuers who have shifted towards issuing more local currency debt in recent years are more likely to experience bond market fragility. We rationalize these facts in a model where foreign households demand money-like claims denominated in their own currency from financiers who intermediate bond markets. Creditor sorting and bond fire sales arise endogenously from a complementarity between the open-end funding structure and the exchange rate risk embedded in local-currency debt. Our findings lean against conventional policy wisdom about the benefits of local-currency financing for financial stability.

Regulators in many emerging markets face a tradeoff: Restricting banks from holding currency mismatches on balance sheet may result in more widespread currency mismatch among bank-dependent domestic firms, including small and medium-sized enterprises (SME). This paper studies the macroeconomic costs of widespread dollar-denominated bank lending in a small open economy. Using micro data from Peru, we document that liability dollarization is substantial across the firm size distribution, including non-tradable sectors and for small, bank-dependent firms. We develop a model to quantify the costs of currency devaluations given heterogeneous firm liabilities. Aggregate outcomes following a depreciation depend on the joint distribution of firms’ foreign currency exposures and their marginal propensities to invest out of liquidity, which are particularly high for small, bank-dependent firms. Estimating the model on the universe of Peruvian firm-level borrowing, we find that depreciations are significantly more contractionary than predicted by representative-firm models. We conclude that small firms’ exposure to foreign currency debt is a key macroeconomic channel of devaluation costs.

We introduce a theory where dollarization arises as a risk transfer between domestic firms and households, who hedge against inflation and income risks from local currency depreciation. Dollarization increases when these risks are higher, resulting in large UIP deviations. Country-level evidence shows that 80% of dollarization is driven by income hedging. Using household-level data from Uruguay to account for individual pass-through effects, we find that households save in dollars to protect against exchange rate pass-through into prices and, to a lesser degree, wage reductions. Surprisingly, capital controls increase domestic dollarization, exacerbating firms’ currency mismatches and undermining their original intent.